THE INCENTIVES FOR COST REDUCTION IN A DIFFERENTIATED INDUSTRY

This paper investigates how the incentives for cost reduction in a dif ferentiated industry depend upon the degree of product substitutabilit y. When goods are imperfect substitutes, both Cournot and Bertrand com petition result in underinvestment in the sense that a social planner would be willing to pay more for a given cost reduction than a profit- maximizing firm. Overinvestment may occur when the goods are sufficien tly close substitutes. Similarly, Cournot competition provides a stron ger incentive to innovate than Bertrand competition if the degree of s ubstitutability is low, and a weaker incentive if this degree is high.